Investor gets fund's dividends whether he sells or not

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Donald F. in Minneapolis is fed up with a mutual fund in his IRA and is ready to make the leap to something better.

He just doesn't want to leave anything on the table.

"I don't know if the fund will be paying dividends this year," he said in an e-mail. "How can I determine if a fund is going to pay dividends and get an estimate of how much?"

It's a question a lot of investors ask at this time of year, but it also shows an alarming lack of understanding about how mutual funds actually work, and it highlights how ignorance of the finer points of funds can be costly.

To see why, let's delve into Don's question, and see where his thinking went off track.

Mutual funds are "pass-through entities," meaning that tax liabilities incurred holding or trading securities pass through the fund and on to shareholders. By law, funds must distribute at least 98 percent of the dividends and capital gains - profits made when investments are sold - realized each year.

So the answer to Don's question is that most stock funds make annual distributions in December but estimate those payouts in mid- to late November. Firms that make estimates - because not all of them do - make those numbers available by phone or on the firm's Web site.

Don's thinking - and I called him to confirm it - was that funds act similarly to individual stocks. With a stock, if you sell out the day before the record date for the next dividend, you miss the payout. "I don't like to give up a dividend I have earned," Don explained.

But with a mutual fund, the dividends and capital gains build up over the course of the year and become part of the net asset value. Let's say that a fund owns XYZ stock when it pays a dividend. If the payout is equal to, say, a penny for every outstanding share in the mutual fund, the fund's share price will rise by 1 cent when the distribution arrives.

Over the course of a year, those gains build up. When a fund makes its distribution at the end of the year, the money comes right off the top, so that a $1 per share distribution from a fund trading at $11 per share will immediately drive the post-payout price down to $10.

In short, Don gets the fund's dividends whether he waits for the distribution or not. Say he has $11,000 invested in the fund with the $11 share price. He gets $1,000 in dividends and capital gains, which he rolls back into more shares. Before the distribution, he had 1,000 shares at $11 each; after the payout, he has 1,100 shares at $10 each.

Before or after, the investment is equal to $11,000.

Don holds the fund in a retirement account, so dropping the fund now is not a taxable event. Even in a taxable account, however, the difference between selling before and after the distribution date most likely is minimal; with both capital gains and long-term dividends subject to the same maximum tax rate, there could be some benefit to ejecting before the distribution, but the difference in most cases will be marginal.

There is, however, a difference when it comes to buying a mutual fund right before the annual distribution. If you are buying the fund for an IRA - as Don will do once he makes his change - current distributions are not your problem, as you'll settle up with Uncle Sam when the money ultimately is withdrawn from the account.

But if you get the fund in a taxable account so much as a day before the payout, the government will want its share of your distributions next April, even if you reinvest the payout and never touch the cash.

Here again, investors need to be careful to avoid distribution confusion. Say the investor with $11,000 in the $11 per share fund made the purchase before the distribution. He'll owe taxes on the $1,000 distribution, but if he rolls that money back into the fund, he has now invested $12,000 in the fund, raising the cost-basis on the fund to about $10.90 per share. That higher price per share will reduce the taxes owed when the fund is sold in the future, effectively allowing the investor to catch up from paying taxes now on the distribution.

Fail to adjust the cost-basis and you will pay taxes twice, first on the distribution and then for failing to act like the rolled-over monies were part of your purchase price.

"It's definitely confusing," says Don, "but it's actually easier than I thought. ... Once you know how it works, you don't worry so much about making a mistake."

cjaffe@marketwatch.com

Charles Jaffe is senior columnist for MarketWatch. He can be reached by mail at Box 70, Cohasset, MA 02025-0070.